Decision Analysis for the Emission-limited Manufacturer with Option Contracts under Demand Uncertainty

Abstract

Emission options have been introduced to relieve the emission-dependent manufacturers’ low-carbon pressure and contribute to the long-run success of the Emission Trading Scheme (ETS). Yet few research works have studied the manufacturer’s behaviors and performance with/without emission options to achieve sustainability. This paper seeks to bridge this research gap and investigate the manufacturer’s optimal emission purchasing and product pricing strategy under the ETS. Newsvendor models are adopted with originality in the use of the Lagrange Multipliers and KKT conditions to achieve optimality subject to emission constraints. Although this approach has rarely been used in the emission-constrained production, it is found effective to achieve optimality subject to emission constraints, especially when economic instruments like options are considered. Mathematical analysis and numerical results show that options increase customer demand and profitability of the firm in a stringent emission market when the price-sensitivity is not too high, and that reasonable option pricing is vital to the emission trading market. As such, a new method is developed for achieving profitability and emission reduction via option contracts.